Mortgage refinancing involves replacing your existing mortgage with a new one, often to get a lower interest rate or monthly payments. Key factors to consider include current mortgage rates, your home equity, and the costs of refinancing. It can be beneficial for homeowners looking to switch from an adjustable-rate to a fixed-rate mortgage or to shorten their loan term. Refinancing comes with fees and closing costs, so it’s important to weigh any savings against these expenses before deciding.
Key Takeaways
- Refinancing can lower your monthly mortgage payments if you secure a lower interest rate.
- Consider your home equity, credit score, and refinancing costs before deciding to refinance.
- A cash-out refinance can help access home equity for expenses or debt consolidation, but it comes at a cost.
- Refinancing for a shorter loan term can save you significant interest over time.
- Switching from an adjustable-rate mortgage to a fixed-rate mortgage can offer stability against rising interest rates.
When Should You Refinance?
Refinancing your mortgage is a big step. As such, there are several things you should consider before you sign the paperwork. Most borrowers consider mortgage rates they want to refinance. Locking in a lower rate is an important factor to consider when you want to refinance because it effectively lowers your payments. But it shouldn’t be the only thing to focus on when you want to renew your mortgage.
Here are a few other factors to consider before you apply:
- Your home equity. Make sure you have equity available in your home. This is key if the value of your home drops below the value when you purchased it. It’s also important to note that many lenders (especially conventional lenders) won’t refinance your mortgage if you don’t have enough equity in your home.
- Your credit history. You won’t qualify for a refinance if your credit score doesn’t meet the minimum requirements. Take the time to build up your credit score before you apply.
- Refinancing costs. If you have a mortgage, you’ll know how much you paid in additional costs. As such, you’ll have to pay these expenses again—usually a small percentage of the loan. Try to find ways to negotiate so you can reduce the costs.
Other points you’ll want to note are your debt-to-income (DTI) ratio, the overall term of the refinance, and whether you qualify for refinance points to reduce the interest rate on the loan.
Tip: Ask yourself if refinancing makes sense. How long do you intend to occupy the property? Will you end up saving more money if you refinance? Answering these questions will help you decide whether or not you should take this step.
Lower Your Interest Rate Through Refinancing
One of the best and most common reasons to refinance is to lower your loan’s interest rate. Historically, the rule of thumb has been that refinancing is a good idea if you can reduce your interest rate by at least 2%. However, many lenders say 1% savings is enough of an incentive to refinance. Using a mortgage calculator can help you see how much you might save.
A lower interest rate will save you on short- and long-term interest while reducing your monthly payments. For example, a $100,000, 30-year fixed-rate mortgage with an interest rate of 7% has a principal and interest payment of $665. That same loan at 5% reduces your payment to $536.
Reduce Your Loan Term With Refinancing
When interest rates fall, homeowners sometimes have the opportunity to refinance an existing loan for another loan that, without much change in the monthly payment, has a significantly shorter term and can save them a considerable amount of interest over time.\
For example, suppose you purchased a $200,000 home with 20% ($40,000) down and a 30-year fixed-rate mortgage for $160,000 at 8%. Using Investopedia’s mortgage calculator, which also builds in some assumptions about property taxes and insurance, your monthly payments would be about $1,419, and over the course of the loan, you’d pay $262,648 in interest, making your total repayment $422,648.
If interest rates dropped, and you could get a 15-year fixed-rate mortgage at 6%, your monthly payments would rise to about $1,594. While that’s $175 more than your current mortgage, you’d now own your home free and clear in 15 years. Plus, your total interest payments would be just $83,030.
Note that this simplified example doesn’t account for the fact that whatever payments you had already made on your 30-year mortgage would have reduced the outstanding balance of your loan to some degree, so when you took out the 15-year mortgage, you wouldn’t need to borrow the full $160,000. In other words, your savings could be even greater.
Warning
Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development.
Switch Between ARM and Fixed-Rate With Refinancing
While adjustable-rate mortgages (ARMs) often start with lower rates than fixed-rate mortgages, periodic adjustments can lead to rates as high as those available on new fixed-rate mortgages. Refinancing to a fixed-rate mortgage is a way to avoid future interest rate hikes.
Conversely, converting from a fixed-rate loan to a new ARM with a lower monthly payment can sometimes make sense, especially for homeowners who do not plan to stay in their homes for over a few years. Depending on the ARM, it may not adjust for the first five, seven, or even 10 years, making it essentially a fixed-rate loan for that period.1
Unlock Home Equity or Consolidate Debt Through Refinancing
Homeowners can also refinance as a way of tapping some of the equity that has built up in their homes over the years through what is known as a cash-out refinancing.
In cash-out refinancing, the homeowner takes out a mortgage larger than they currently owe, pays off the old mortgage, and pockets the remainder in cash. The cash can be used for any purpose, such as home remodeling, a child’s college education, or to consolidate and pay off their other, higher-interest debts, such as credit cards.
The downside is that the cash comes at a cost, and the homeowner could be paying interest on it for many years. So, these loans aren’t to be entered into lightly. In particular, homeowners may want to be judicious in how much cash they take out. For example, if a homeowner can cash out $100,000 by refinancing but only needs $25,000, there’s no sense in borrowing (and paying interest on) the other $75,000.
What Credit Score Do You Need to Refinance a Mortgage?
In most cases, you’ll need a credit score of at least 620 to qualify for refinancing.2 However, there are exceptions, such as FHA loans, where lower scores may be acceptable.3
Is Mortgage Interest Tax Deductible in a Refinancing?
Yes, the mortgage interest for a homeowner’s main home is tax-deductible, up to certain limits. Homeowners who are married and file taxes jointly may generally deduct the interest on up to $750,000 in mortgage debts; for single filers, the limit is $375,000. The rules for deducting interest on second homes are more complicated, depending on how the home is used.
In addition, to claim mortgage interest as a tax deduction, the homeowner must itemize deductions on their taxes rather than claim the standard deduction.4 The standard deduction was raised significantly in 2017, so many taxpayers no longer find it advantageous to itemize.5
Are Mortgage Points Deductible in a Refinancing?
Mortgage points, a form of prepaid interest, are deductible in refinancing, just as with an original mortgage. In most cases, they must be spread out and deducted over the life of the loan. The exception is if the refinancing was used for home improvements to your main home; in that case, you may be eligible to deduct them in the year you paid them.
As with other mortgage interest, points are deductible only if you itemize your deductions.6
Is the Cash Received in a Cash-Out Refinancing Considered Taxable Income?
The cash from a cash-out refinancing is not generally considered taxable income because, as the IRS puts it, “you have an obligation to repay the lender later.” However, if the lender later cancels the debt, that amount becomes part of your taxable income.7
Can You Refinance a Home Equity Loan?
You can refinance a home equity loan with another home equity loan or a home equity line of credit if you have sufficient equity in the home. You might consider doing that if you can get a substantially lower interest rate or wish to borrow more money or extend your current loan term. However, you’ll want to take closing costs into account to determine whether refinancing will be worth it.
The Bottom Line
Mortgage refinancing can help you secure a lower interest rate, shorten your loan term, or tap into your available home equity for other financial goals. But evaluate the refinancing costs and potential long-term savings to make sure they make sense for you before you apply. Consider factors like how long you plan to stay in your home, how the new loan affects monthly payments, and whether it aligns with your overall financial objectives. Using a mortgage calculator can help you compare your current and new terms to see if refinancing truly benefits you.
Source: investopedia.com ~ By: The Investopedia Team ~ Image: Canva Pro